Man the Barricades: Is a Trade War on the Horizon?

Call it a sign of the times. A small article appearing earlier this month in a national daily newspaper reported the imminent closure of a light bulb factory in Virginia, lamenting not only yet more workers (in this case 200) losing their jobs, but also the demise of U.S. manufacturing — victims of lower-cost competitors overseas and the unintended consequences of government policy.

For some U.S. policymakers, it’s the type of news that provides even more reason to go on the war path against foes in the Obama administration, which stands accused of not doing enough to protect the national economy from unfair foreign competition. Anger is also directed at the country’s big trading partners, which some say are responsible for creating a large global trade imbalance and derailing national efforts to recover from the Great Recession by exporting too much and importing too little.

According to some observers, the increasingly loud political rumblings are the sound of politicians pandering to the populist electorate before mid-term elections in November. But even relatively positive economic news over the past weeks — such as a 1% jump in U.S. industrial output this summer — has done little to calm Capitol Hill as the U.S. sputters out of recession. The Organisation for Economic Co-Operation and Development, among others, forecasts a slowdown of fourth quarter GDP growth, to 1.2% from 2% the previous quarter; the national unemployment rate is still hovering stubbornly high at just under 10%; and — critically for trade hawks — the country continues to under-save and over-consume while its trade deficit in goods and services balloons. The deficit increased to $290 billion in the first seven months of this year, compared with $204 billion over the same period in 2009.

To fire up the economy, President Obama vowed in July to double American exports over the next five years. “But how?” asks Bernard Hoekman, sector director of the World Bank’s trade department. “That is not going to be very easy if you’re not pursuing an aggressive trade policy strategy to get better access to other markets.” Meanwhile, Obama’s opponents in Washington have a different agenda in mind — their aim is to push through policies that make it harder for imports to enter the country.

It is enough to ring alarm bells. “The [trade] deficit combined with high levels of unemployment and job insecurity could unleash another round of protectionism,” warns Stephen J. Kobrin, professor of multinational management at Wharton. “But it is not clear to me how much of the reaction to the deficit among politicians is noise and how much is an actual concern.”

Either way, there is a growing debate in free-trade circles whether a global trade war could erupt if other countries retaliate by erecting their own barriers. It’s a scenario brushed aside by trade overseers at the World Trade Organization (WTO), who say the dispute mechanisms they provide to disgruntled countries lay such concerns to rest. In an interview with Forbes magazine, WTO head Pascal Lamy maintained, “We are not in a planet where there can be trade wars anymore,” but rather “trade frictions.”

Even less bullish observers don’t expect a repeat of, say, the 1930s, when major tit-for-tat disputes erupted around the globe after the U.S. jacked up import tariffs. But there is much work to be done to ease “frictions” in not only the U.S., but also major trade-surplus countries, like China and Germany. The key, according to experts, is to start addressing the thorny causes of the trade imbalances, a crucial step to ensuring a sustainably robust global economy. They say pressure must be put on both the surplus countries and the deficit countries, and that each nation must consider different dimensions of adjustment and policy reform agendas.

Sharing the Burden

“A trade deficit is a mutual problem; the surplus countries may be saving too much, but the deficit countries are clearly saving too little,” states Richard J. Herring, a Wharton finance professor. “Adjustment will be less onerous if both the surplus and deficit countries share the burden. But in reality, the pressures are asymmetric and deficit countries face constraints long before surplus countries do.”

That said, China — the world’s largest exporter — has been facing plenty of pressure, largely in the form of political arm-twisting from Washington. China’s global goods surplus hit a record $295 billion in 2008, which narrowed to $196 billion last year, while the goods deficit in the U.S. — its second-largest trading partner after the European Union — was $840 billion and $517 billion in 2008 and 2009, respectively. In the first five months of 2010, China’s trade surplus with the U.S. rose 10% from the previous year, to $93 billion, according to the American Commerce Department.

Undeniably, a big reason for China’s export growth — which contributes to 40% of its GDP — is the iron grip that Premier Wen Jiabao’s government keeps on its currency’s exchange rate. It is one example of how the Chinese play an “almost mercantilist” role, says Wharton adjunct faculty member Gerald McDermott, a professor of international business at the University of South Carolina’s Moore School of Business. “They’re trying to force open as much access [to overseas markets as they can].”

By keeping the value of the renminbi (RMB) artificially low against the dollar, the government has fueled demand for its low-cost, made-in-China goods worldwide. “China has manipulated its exchange rate as a way of absorbing its excess [of] underemployed labor, largely from the interior of the country. There are both political stability and economic growth motives behind this,” observes Herring. “But because China has become so large, there are severe limits to its export-led growth unless it is willing to continue accumulating large amounts of foreign currencies, which are likely to depreciate vis-à-vis the RMB.”

In early summer, China appeared to be bowing to U.S. pressure when it said it would allow more flexibility in the RMB’s exchange rate than it has over the past few years. But the rise in the RMB since the announcement has been minimal — to RMB 6.77 against the dollar in early September from about RMB 6.83 in June. It has left some U.S. politicians unimpressed. Representatives Tim Ryan, an Ohio Democrat, and Tim Murphy, a Pennsylvania Republican, are currently sponsoring a bill to let companies petition for higher duties on imports from China to compensate for the effect of the weak RMB.

It’s widely assumed that if China does decrease exports, it will want to make up for the loss of revenue by encouraging domestic consumption. That is a tall order. “[China’s] problem, and they are very aware of it, is that while they are a very big country, [the population is generally] very poor,” notes McDermott. In 2008, the average annual income of an urban household in China was less than $5,000, according to new research from the National Economic Research Institute, an independent nongovernmental research organization in China.

What’s more, unlike the U.S., China is a nation of savers, not consumers. Gross domestic savings as a percentage of GDP in China in 2009 was 50%, compared with just over 10% in the U.S. Spurring the Chinese to spend — and consume more domestic and foreign goods — rather than save hinges on a lot of factors, including whether the government starts providing robust pension and health care safety nets.

China also wants to upgrade its reputation as the low-cost manufacturer to the world. McDermott says research has found that the margins on many of the high-tech goods it manufactures are in the low single digits, compared with countries like Taiwan and Korea, which are capturing as much as 50%. “China knows that trade competitiveness is not determined by costs alone,” adds McDermott. “They have invested an incredible amount in engineers and high tech, with mixed results.”

The Wunder Economy

Another country at the center of the global trade imbalance debate is Germany, which was usurped by China last year as the world’s top exporter. It recorded an international trade surplus of$189.7 million in 2009, compared with $266 million in 2008. According to figures released earlier this month by Destatis, Germany’s statistics office, the country’s exports in the first half of this year continued to grow faster than imports, resulting in a $95 million surplus. (Between January and July, exports to Germany from the U.S. reached $27 billion, compared with $46 billion of imports.)

In many respects, Germany considers itself a model of export-driven growth. Being part of the euro zone, it can’t be accused of currency manipulation like China, and as Herring points out, the country “took the hard, painful [economic] restructuring measures several years ago that most other countries have yet to embrace.”

Having just posted a Apri-to-June growth rate of 2.2% — its strongest quarter since reunification in 1990 — Germany is resistant to changing its course, much to the consternation of some of its trading partners close to home. That includes France’s finance minister, Christine Lagarde, who said in June that Germany’s export engine is threatening the competitiveness of other euro zone countries. Lagarde went so far as to suggest that German Chancellor Angela Merkel cut taxes in order to encourage consumers to spend more and save less in a country whose gross national savings rate as a percentage of GDP is 21.8%.

As long as Merkel resists using policies to increase imports and decrease exports, what can be done? It would be difficult to call in the likes of the WTO, since Germany is following the free-trade book, says Wharton legal studies and business ethics professor Philip Nichols. “They couldn’t ask Germany to distort trade,” he notes. “It undercuts everything that these international institutions [such as the WTO] stand for.”

Changing the behavior of the deficit countries is no less easy. Nowhere is that more apparent — and arguably more urgently needed — than in the U.S. According to Herring, so far the country “has been spared the pressures that most other [deficit] countries face because countries are willing to hold increasing amounts of dollar-denominated debt at minimal interest rates. But this cannot continue indefinitely. And when market sentiment changes, it could happen very quickly.”

The problem is, solutions are neither fast nor easy. “In some ways, what’s needed is a coordinated increase in demand around the world,” suggests Howard Pack, a Wharton professor of business and public policy. It’s an idea the Obama administration has mooted, “but the rest of the world said no way.”

The other route for the U.S. to take is to address deeply embedded structural issues causing high unemployment, over-consumption and capital misallocation — that is, the parts of the economy that ultimately affect trade. An opportunity to do that recently was missed when the Obama administration “did not intervene in the institutions of the economy enough,” McDermott maintains. “Instead of just pumping money into [the banks], they could have forced a restructuring.”

As for the overall stimulus, “we do need some demand priming, but it’s also about where you direct the money.” Rather than focusing on large infrastructure programs, McDermott suggests stimulus money also needs to go to small and midsized enterprises (SMEs) — which are the export engines in many other countries, including Germany.

Like a number of observers, he also cites the need for policies to refocus the country on manufacturing. While U.S. manufacturing output has grown substantially in recent years, it has done so more slowly than, say, the service sector. In 1980, manufacturing composed 21% of the U.S.’s GDP, but the sector has been declining steadily since, hitting 13% in 2008, compared with China’s 32%. “Maintenance and creation of manufacturing is not about trade protection,” adds McDermott. “It’s about strategic economic management.”

Nichols also advises U.S. manufacturers to ignore the politics and “populist aversion” around today’s trade imbalances, which are, after all, numbers that are an “imprecise snapshot” of performance in this age of globalization. “Political borders don’t reflect the commercial reality,” he notes. Economies today are so intertwined that “a trade war is really a war on ourselves.”

The Genie in the Bottle

Recent reactions to the downturn are a promising indication that any sort of trade war can be avoided, says Wharton’s Herring. “Although there have been some protectionist measures in this prolonged recession, most have been aimed at making sure that domestic subsidies do not leak out overseas. And even in this instance, the record is mixed. Most of the [U.S.’s] huge bailout of AIG went to foreign banks. Given the macro-circumstances, I would consider this a triumph of trade diplomacy.”

In terms of what lies ahead, McDermott says that while he doesn’t “see a slippery slope, I do see that if large countries like the U.S. don’t work on restructuring their institutions related to finance and manufacturing, we are entering into a situation in five to 10 years of high structural unemployment [in the U.S.], and that would not be a good political foot on which to move forward.”

What concerns Heribert Dieter, a senior fellow at Berlin-based think tank Stiftung Wissenschaft und Politik (SWP), is that the slow pace of reform could leave U.S. politicians with their backs to the wall, prompting them to resort to onerous trade barriers. “Policymakers are under enormous pressure to come up with something that at least portrays them as efficient managers of the economy,” he points out. “To Obama’s credit, he hasn’t done what people were predicting that he’d do in 2008. So far, trade policy hasn’t become more protectionist.” The problem is that short-term protectionism often leads to long-term protectionism, which is difficult to stop. “It’s hard to put the genie back in the bottle,” states Dieter.

He says the surplus countries need to swing into action, “rather than wait for an unpredictable reaction by the deficit countries — mainly the U.S. — which may come to the conclusion sooner rather than later that stopping imports would be their only option.” But what carrots and sticks can be used? “There [are] zero at the moment,” says Dieter. “There is political pressure, but no instruments.”

Dieter, along with Richard Higgott of the University of Warwick in the U.K., offered two suggestions in a recent book of essays published by the London-based Centre for Economic Policy Research titled, Rebalancing the Global Economy: A Primer for Policymaking. One idea they propose is to raise taxes on cross-border capital flows. “It is not meant to get rid of the cross-border flows or erect harmful restrictions, but in our view it would be useful to slow them down and lengthen their time horizon,” Dieter says. The other idea is for countries with persistently large surpluses to pay a percentage of the surplus into a fund, which would be managed by an international body.

Dieter says he is “under no illusions” that either idea will be met with a consensus, but it is a start. “We put them on the table. It has helped the debate in Germany to focus on the utility of this export-champion model,” he notes. “Exports are not a goal in and of itself. Sometimes Germans and Chinese tend to forget that.”

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